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"Fire Your Stock Analyst" by Harry Domash
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9 stocks you can fall in love with
If dependable growth gets your heart racing, this screen may help put together a portfolio you can take home to mother.
By Harry Domash
With Valentines Day on our doorstep, it's an appropriate time to think about finding stocks worthy of a long-term relationship instead of a one-night stand. What sort of stocks will you still find appealing after that first blush of infatuation has worn thin?
OK, I know Im shallow, but to keep the romance alive, I need low maintenance stocks, the kind that you can depend on to keep moving up in price, if not for an eternity, at least for a few years.
How do you find stocks ready for such a lasting commitment?
For me, its all about finding companies benefiting from a powerful combination of super profitability and fast growth prospects. By super profitability, I mean companies that generate far more earnings than their peers based on two different criteria. Ill explain while I describe my Valentine screen devised to come up with nine stocks that wont break your heart.
You dont have to wait for Valentines Day to see the current picks. Just click here to come up with todays list.
Profitability -- the pros secret revealed
Profitability in general means an owners return on investment. Return on equity, or ROE, the most commonly used profitability gauge, measures the return on the shareholders equity (book value). Its calculated by dividing a company's last four quarters net income by its shareholders equity. Many companies report impressive per-share earnings, but arent really very profitable. Let me explain.
When I last checked, 2,047 companies had reported trailing 12-month EPS of $1 or more. But only 866 stocks, less than half, showed ROEs of 15% or higher. Why is that important?
Heres a little secret that pros know, but many individual investors dont: If you do the math, youll find that a company cant internally fund earnings growth faster than its ROE. For instance, a 10% ROE company cant internally fund more than 10% annual earnings growth.
Sure, many low-ROE companies do grow faster than their ROEs, but at a cost to shareholders. These profitability-challenged companies must continuously raise more cash by borrowing or by selling more shares to fund their growth.
Both alternatives are bad news for shareholders because they reduce future EPS growth. Borrowing increases loan-servicing costs, which, in turn, reduces earnings. Selling more shares dilutes EPS because net income has to be divided by a greater number of shares.
To avoid that treadmill, do like many professional do and avoid low-ROE stocks. Most pros Ive talked to wont touch stocks with ROEs below 15%. But I turned that ROE standard up a few notches to 25% to limit Valentine picks to the best of the best: super-profitable stocks. Only 11% of the stocks in MSNs database met that requirement.
Screening Parameter: Return on Equity >= 25%
High ROE is a good starting definition for super-profitable stocks, but it isnt the whole story. Next, we have to pick the best stocks in each industry. For that, I used a two-step approach:
Industrys best
Industries such as software makers, which dont have to make big investments in plants and machinery, usually report higher ROEs than those that do, such as manufacturing companies. So whats high, in terms of ROE, depends on the industry.
Identifying stocks with ROEs above their industry average is usually enough to identify the market leaders. But were looking for the super profitable, so I required that Valentine stocks ROE exceed the industry average by a whopping 25%. Only 307 stocks in MSNs database with 25% or higher ROEs met that requisite.
Screening Parameter: ROE >= 1.25 Industry Average ROE
How productive are the employees?
The Valentine screen is about finding the most efficient companies, in terms of producing bottom-line earnings. Income per employee, which is yearly net pretax income divided by the total number of employees, tells you how efficiently a company is turning employees efforts into profits. Thats a big deal, since labor is usually one of the biggest cost factors.
As with ROE, the norms for income per employee vary between industries. For instance, major drug manufacturers average $64,000 in pretax profits per employee, while a typical restaurant employee only generates $2,000.
To assure that weve pinpointed the strongest players, the Valentine screen requires that passing stocks exceed their industry average by at least 25% in terms of employee productivity.
Screening Parameter: Income Per Employee >= 1.25 Industry Average Income Per Employee
Debt -- the downside of ROE
Ive emphasized the value of using ROE to measure profitability, but ROE has a downside. All else equal, the higher a company's debt, the higher its ROE. To compensate for that drawback, you have to ensure that high-ROE stocks didnt get that way because theyre carrying above-average debt.
Mind you, theres nothing wrong with high debt if you can invest the borrowed funds productively. Think about it. Wouldnt you borrow all the money you could if you could get it for 5% interest and invest it in something that pays 10%?
So, as with profitability measures, the definition of low debt and high debt depends on the industry. The long-term debt-to-equity ratio is a handy debt measure. Industry average D/E ratios vary from zero for application software company's to 3.2 for automobile makers, and some industries are even higher.
You can diminish the probability that a company's outsized ROE is due to abnormally high debt by stipulating that a passing stocks D/E ratio cant exceed its industry average. But since were looking for the best of the best, I upped the ante and required D/E ratios no higher than 75% of the industry average. Doing that means that Valentine stocks must possess a unique combination of much lower than industry average debt and much higher than average profitability.
Screening Parameter: Debt/Equity Ratio <= 0.75* Industry Average
Bigger is always better
Its just a fact of life that small companies are more likely to let you down than big ones. Like beauty, the definition of big and small is in the eye of the beholder. But most experts would agree that stocks with market capitalizations below $1 billion are riskier than larger companies.
Screening Parameter: Market Capitalization >= $1 billion
Reach for revenue growth
For most companies, earnings growth comes from sales growth. So its hard to love a stock that isnt growing its sales at a decent rate. How much sales growth is enough? A minimum 10% average annual historical sales growth is a reasonable requirement. Higher is better, but only to a point. High growth rates, say 25% or more, cant be maintained and must eventually slow, and that event usually crashes the stock.
Screening Parameter: 5-Year Revenue Growth >= 10%
Forecast earnings growth
Sure, stock analysts sold us out to make a buck in the not-too-distant past. But there is still useful information to be had from their musings, especially their long-term (five-year) earnings growth forecasts. Since earnings growth propels stock prices, theres no point in buying a stock if analysts dont think its going to grow earnings very much. For growth stocks, 15% average annual earnings growth should be the minimum forecast. As with sales growth, more is better, but only to a point. Forecast earnings growth rates much above 25% cant be maintained indefinitely.
EPS Growth Next 5 Years >= 15%
Perusing the price chart
Weve all heard that we should buy low and sell high, but in all too many instances, stocks that have already outperformed the market go on winning, while underperformers continue to disappoint. Youll increase your chances of picking a winning stock by limiting the field to stocks that have performed on par with the overall market, at the very least.
Relative strength measures a stocks price performance compared to all stocks over a specified period. An RS of 90, for example, means that the stock has outperformed 90% of all stocks in terms of percentage price appreciation. A 50% RS means that the stock has performed about average, which is our minimum requirement. Whats the best timeframe to measure RS? MSNs Deluxe Screener offers three options: three months, six months and 12 months. Since were looking for a long-term relationship, 12-months is your best choice.
12-Month Relative Strength >= 50%
9 real lookers
My Valentines Day screen turned up nine candidates:
| Valentine Stocks | | Company | Industry Name | Recent Price | | Strayer Education (STRA, news, msgs) | Education & training services | $114.23 | | ITT Educational Services (ESI, news, msgs) | Education & training services | 55.20 | | Chico's FAS (CHS, news, msgs) | Apparel stores | 38.47 | | Teva Pharmaceutical Industries (TEVA, news, msgs) | Drug manufacturers - other | 64.66 | | Lennar Corporation (LEN, news, msgs) | Residential construction | 44.69 | | H&R Block (HRB, news, msgs) | Personal services | 59.02 | | Suncor Energy (SU, news, msgs) | Oil & gas refining & marketing | 26.07 | | Ross Stores (ROST, news, msgs) | Apparel stores | 28.26 | | Forest Laboratories (FRX, news, msgs) | Drug manufacturers - Other | 76.03 |
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The group was reasonably diverse with three duplications in terms of industries. However, only Teva Pharmaceutical and Forest Laboratories, both generic drug makers, are direct competitors. Chicos FAS and Ross Stores, although both clothing retailers, serve different markets. Chicos focuses on womens fashions while Ross is a discount store carrying mens, womens and childrens clothing. Strayer Education and ITT Educational Services both are adult educators, but ITT offers technology-oriented classes while Strayer offers degrees in a variety of different fields.
As is always the case, the results of the Valentines Day screen are stocks worth analyzing, not a buy list. So if you are smitten, it's time to wipe the silly smile off your face and continue your research.
At the time of publication, Harry Domash did not own or control positions, either long or short, in any of the stocks mentioned in this column.
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